“Nowhere to run to baby, Nowhere to hide”
Nowhere to Run, Martha and the Vandellas, written by B. Holland, L. Dozier and E. Holland Jr., Motown Records, 1965
Familiar refrains dominated the second quarter: high inflation; aggressive efforts by central banks to tame that inflation; and volatile capital markets (stocks, bonds, commodities, and currencies) responding to these rapidly changing realities. The most significant shift is an escalating fear that central banks will raise interest rates too high, too fast and spark a recession.
Three key developments in the quarter stoked recession fears. First, global inflation accelerated. Second, one bellwether survey shows U.S. consumer confidence at an all-time low, while consumers’ expectations for inflation in the medium-term are accelerating sharply. Third, the U.S. Federal Reserve (the Fed) raised interest rates a hawkish 0.75%, its biggest increase in 28 years.
Investors had nowhere to run and nowhere to hide. Major indices (for example, the S&P 500, Europe Stoxx 50, NASDAQ, and MSCI Emerging Markets) are all in bear market territory (down 20% from their prior peaks). Canada’s S&P/TSX Composite, thus far insulated by its heavy tilt to oil and mining stocks, also fell.
When investors worry a recession is looming (Google searches for “recession” are near historic highs), they often quit equities for the relative safety of bonds. At the mid-point of 2022, however, Canadian bond investors have endured two consecutive quarters of losses, a rare double blow recorded just seven times in 40 years. (There was only one three-peat, back in 1981.) A substantial rebound followed each of these declines.
We believe that the year-to-date price adjustments are working off excesses and imbalances in the world's capital markets and are rightsizing asset prices in a post-pandemic, inflationary, and geopolitically tense world.
For fixed income, this means returning some income into the equation for investors. Coupon payments and maturing bonds are now being reinvested at higher yields. The low-interest-rate environment of years prior was an undesirable situation. It reflected a poor economic backdrop and low yields punished savers. So far, adjustment to higher yields has been rapid, and the hit to fixed income portfolios severe – this year’s two-quarter decline is by far the worst on record. We feel this necessary adjustment in bond yields is much closer to the end than the beginning. We also believe fixed income remains a solid risk-mitigation tool and is better positioned today. Support for this belief came in June. As recession fears escalated, longer-term bond yields (10-year Government of Canada) crested and came off their peak of 3.62% to end the month at 3.22%.
If we have a recession, it will be because demand has been outstripping supply and needs to be cooled. Currently, there are more jobs than workers to fill them, too few houses and autos for sale, and not enough food and energy to meet demand. The worst recessions typically feature the opposite conditions.
Unemployment is at or near pre-pandemic and historic lows in both the U.S. and Canada. The U.S. inventory of homes for sale is near an all-time low of 2.6 months versus between 10 and 12 months of inventory just before 2009’s housing bust. U.S. auto dealers have fewer than 100,000 vehicles on their lots; the usual number is 15 times that. Canadian home prices are up 36% from pre-pandemic levels. Demand is there, but affordability is not. Rising mortgage rates will cool demand and hence prices, a necessary but fragile reset. On the goods side, evidence is mounting that price discounts are coming as inventories swell. This should bring welcome relief, even though inflation from housing and wages will likely remain. If a recession is necessary to stomp out inflation, numbers like the ones above should make for a shallow, “jobs plentiful” recession.
Inflation is a part of the process of fixing supply and demand imbalances. When prices rise, consumers change their buying behaviour, and capital channels resources to areas where supply is short. These adjustments are working. U.S. shale oil output is rising, and OPEC is talking about increasing production. Canada is forecast to increase its grain and oilseed harvest by 33% compared to 2021. Commodity prices are already retreating from their war-induced spikes; oil, wheat, copper and lumber prices are all off their highs from earlier this year. When you are trying to tame demand, it’s a good thing to have signs of a cooling economy. Unfortunately, these same markers indicate that the economy could be headed for a shallow recession.
Going into 2022, stock markets faced three major problems.
Exuberance and excess risk-taking behaviour had to be tamed. Mission accomplished, based on the decline of so-called meme stocks (GameStop, AMC, BlackBerry), ARK Innovation ETF, and cryptocurrencies, each down by about 70%.
Stock market valuations, which are sensitive to prevailing bond yields, needed a reset as global bond yields have moved higher. All major markets are now trading at price-to-earnings multiples below their 10-year average, a significant improvement.
Meanwhile, the earnings side of stock valuations (price-to-earnings ratios) may be a shoe waiting to drop. To date, estimates of corporate earnings have not adjusted down to reflect the hit that earnings typically face in a slower growth (or recession) environment, coupled with rising costs. This remains a work in progress.
Canada — Still in growth mode
In June, the S&P/TSX Composite declined 9.0%. All 11 sectors were down – even former superstars energy and materials. Recession fears prompted a retreat in commodity prices that spiked after Russia invaded Ukraine.
The Bank of Canada increased its policy rate by 50 basis points to 1.5%. May's annual Consumer Price Index (CPI) inflation rate accelerated to 7.7%, so more rate hikes are coming. Our economy grew 0.3% in April, a positive start to Q2. WTI oil traded between US$104.27 and US$122.11 a barrel in June. Gold prices traded near their year-to-date low, just above US$1,800/oz. A robust greenback and lower oil prices punished the loonie; it ended June at US$0.78 or CAD$1.29. In the bond market, the Canadian yield curve shifted up in a largely parallel move; the 2-year yield increased from 2.66% to 3.09%, while the 10-year yield rose from 2.89% to 3.22%.
United States — Signs of slowing
Although the world’s largest economy continued to show signs of growth, Q2 indicated that the pace of expansion has begun to slow. Now entrenched in one of its most ambitious rate-hiking cycles ever, the Fed is looking to combat a 40-year high CPI inflation rate (8.6% year over year in May). The housing market is cooling as 30-year fixed mortgage rates average 5.6%, up from 2.99% in June 2021. On a positive note, the Fed’s preferred inflation measure (core PCE deflator) registered a third consecutive monthly decline. However, inflation is up 4.7% year over year, so it seems certain that the central bank will continue to hike this year. Encouragingly, faith that the Fed will tame inflation remains solid. Forward inflation expectations have begun to fall, and markets are now pricing in rate cuts as early as May 2023.
U.S. government bond yields rose across the curve while the U.S. yield curve came close to inversion. This red flag adds to fears that the U.S. economy may flirt with recession, although this is not our base case scenario. The 2-year yield increased from 2.56% to 2.95%, while the 10-year rose from 2.84% to 3.01%. The S&P 500 posted its worst start since 1970, dropping 20.6% during the first six months of 2022.
Europe — Struggles continue
The EU and U.K. have some of the developed world's highest inflation – many countries are posting yearly headline inflation between 8% and 10%. The European Central Bank (ECB) is taking a slower approach to raising interest rates because the risk of recession is higher thanks to slower growth and elevated geopolitical uncertainties.
Consumers are feeling the pinch, and politicians are delivering relief. Governments are rolling out various subsidy schemes to help defray cost-of-living increases. Consumer confidence and forward-looking business activity indicators point to slower growth, but the situation is less dire than we might expect. European bond yields aren’t waiting for the ECB; they moved higher alongside global bond yields. Benchmark German 10-year bund yields skyrocketed from negative terrain in Q1 2022 to as high as 1.76% before settling back to 1.23% to end June. For the month, the Europe STOXX 50, German DAX, and U.K. FTSE 100 stock market indices fell -8.8%, -11.2%, and -5.8%, respectively.
Asia — Swimming against the tide is tough
Now that China is rolling back COVID-19 lockdowns, indicators point to a modest recovery. China’s central bank stands apart from its global peers in pursuing policies to stimulate the economy. Authorities have hinted that they will relax the country’s zero-COVID quarantine rules in order to better balance pandemic control with economic growth. For June, Chinese equity markets were top global performers. China's Shanghai Composite and Hong Kong's Hang Seng indices rose 6.7% and 2.1%, respectively.
The Bank of Japan also stuck with its accommodative policies, which tanked the Japanese yen to a 20-year low against the U.S. dollar. It’s not clear whether Japanese authorities will have the resolve and ability to keep fending off rising global bond yields. A weak yen benefits Japanese exporters.
In June, the benchmark Nikkei 225 was a relative outperformer in local currency (-3.25%). For Canadian investors, the June figure translates to -7.8% in Canadian dollars because the Japanese yen has lost so much value.
Our strategy
Our asset allocation remains close to our long-term strategic benchmarks, with some prudent tactical tweaks. Coupon income and maturing securities in our bond portfolios are being reinvested at higher yields. We believe our bond positions will provide a level of safety if a recession takes hold.
We remain slightly overweight to equities – stocks have historically weathered inflation better than other asset classes. We have rebalanced those portfolios where market price movements have shifted the asset mix away from our desired targets. Specifically, in portfolios with exposure, we purchased emerging market equities to maintain allocations closer to desired weights.
We favour Canadian and U.S. equities. Canada’s commodity-related companies do well in inflationary environments. U.S. equity markets have historically offered relative safety in weak global growth environments.
The last word
Bear markets are scary. It’s also frustrating that bonds are not currently playing their typical role as ballast to portfolios. However, when a recession seems possible, investors are wise to navigate through it, not around it. There really is nowhere to run and nowhere to hide. History has proven that it’s a fool's errand to try to time capital markets by making significant moves in and out of cash.
What does navigating through it mean? Stay well balanced, keep a cool head, know that diversification works. Time is your ally; remember your time horizon. By nature, markets can be volatile. If your circumstances have changed so much that you can no longer stomach the current level of volatility, that is a reason to reassess – not the volatility itself.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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